How to fix the banking sector

As London’s banking sector lurches from one crisis to another, ordinary Londoners can only despair at how long it is taking regulators to clean up the city. Following a series of government-commissioned reviews of the city’s practices — from the Vickers report on banking to the Kay review on equity markets – one could be forgiven for assuming that the authorities are close to regaining control.

The causes of the original 2007 credit crisis can be summed up by three phrases: the bonus culture, moral hazard and conflicts of interest. Yet, despite the burning of midnight oil by Treasury officials, Bank of England supervisors and academic experts all producing pages upon pages of post-event analysis, the government still appears to be clueless about what the core problem in the banking sector is or how to go about fixing it.

Moreover, with a series of fresh scandals breaking out in recent weeks, many experts are now calling into question the scope and conclusions of some of these earlier assessments of the state of the banking sector. Just a few months ago, when the bonus season kicked off, many of the larger investment banks insisted on paying out bumper bonuses to their staff. Yet this time it wasn’t left-wing protestors that questioned their rationale; it was their own investors who argued that bank employees were taking out far too much in relation to bank owners, shareholders. Then there were the series of mis-selling scandals involving mis-sold insurance and other financial products, costing bank shareholders £8 billion in fines alone. Then JP Morgan, the golden boy of risk management, informed us of its own failure to manage risk, resulting in losses of $6 billion and rising. Then the LIBOR scandal erupted where traders at a multitude of banks were involved in attempting to rig key interest rates used by governments, corporations and homebuyers around the world. Finally, RBS allowed its IT controls to deteriorate to such an extent that its entire banking system crashed in the aftermath of a botched software upgrade, causing millions of customers to lose access to their funds for days.

The core problem for London’s investment banking sector is a problem of culture. Sort out this cultural problem and the three main causes of the banking crisis — the bonus system, moral hazard and conflicts of interest — can eventually be overcome.

The bonus culture
In the boom years, bankers justified record bonuses by pointing to record profits. In the barren years, they justified record bonuses by pointing to how fast they could turn record losses into record profits again.

And herein lies the problem. You see, the problem with banking is that you never know what profit you’ve actually made until years — sometimes decades — later. It’s always a guess. After all, many bank executives reported record profits to their shareholders in 2005 and 2006 only to hit them with the biggest banking losses in banking history just a year later in 2008.

Banking profits are much harder to calculate than profits in other industries. Take motor cars. At Ford, things are pretty simple. They bought this much steel, this much plastic, put it together with a bit of electronics and wheeled out this many cars. Make a few adjustments and hey presto, this is your profit — or loss in their case. The key thing is, in the majority of industries, most of that profit is actually generated by selling your product and banking the cash. Profits will, of course, be manipulated by accounting adjustments and be affected by year end stock levels. But the maximum stock a car company, say, might hold could be a month’s worth of cars, maybe two months.

At a bank the maximum stock — by way of loans — could be 20 years. So we cannot be sure how much profit the bank will make on some of these loans until twenty years from now! But whilst a bank’s profitability can only be sensibly estimated over the long term, bonuses are paid out in the short term. If things turn sour from one year to the next and you’ve paid out too much in bonuses — tough.

Banks can manipulate profits like my baby daughter can manipulate her daddy. Banks calculate a big element of their profits not by what they’ve sold, but by pricing what they haven’t sold. In the jargon, it’s called “mark to market.” These profits are sent up or down at the click of a computer mouse. They’re not based on real sales — like they are at Ford, or Apple or McDonalds. They’re based on guessing the value of their assets. But that guess is rigged. Because the higher the valuation of those assets, the higher the bonus pool for the banks’ key executives. By the time we figure out what the real value of a bank’s assets are — the bonuses have already bolted out the door. And all your left holding in your hand is the same stuff that I’ve got every morning right after my daughter’s nappy change. And it stinks.

The banking industry’s line on bonuses is, of course, predictable: Talent has to be rewarded. Risk takers have to be rewarded. Last year the global banks set aside over £100 billion for their bonus pools. Yet what risk have banking employees taken at a time when their entire business has been underwritten by taxpayers? George Soros, the legendary investor, summed this up in an interview he gave to the Financial Times in the midst of the banking crisis, “Those earnings [referring to bankers bonuses] are not the achievement of risk-takers. These are gifts, hidden gifts, from the government.”
But banks don’t sell hamburgers, or cars or iPads. Banks sell trust. You go to a bank, hand over your money and trust that they will look after it. When you’re in the trust business, you have to act honorably. And honor simply doesn’t sit comfortably with million dollar bonuses.

So to those people who say that we need to reward talent with multi-million-dollar bonuses, I say you’re hiring exactly the wrong kind of talent.

Moral hazard
Some would say that if you live by the sword die, you should die by the sword. The sword of bankers is capitalism. The first rule of capitalism is that you should protect capital; yet all banks failed to do that. The second rule of capitalism is that it is survival of the fittest; yet bankers expect taxpayers to bail them out when they lead their businesses to the brink of bankruptcy. The third rule of capitalism is that the providers of capital should reap the biggest rewards. Yet the biggest provider of capital to UK banks over the last five years has been the UK government — on behalf of the UK taxpayer. We have provided direct capital injections into banks like RBS and HBOS and indirect capital support to banks like HSBC and Barclays, who would have lower profits had taxpayer’s money not come to their assistance. Yet, as the largest provider of capital, the UK government seems to have little control over how its own capital is allocated. No doubt that is partly because the capital was handed over to the banks at a time of crisis, when the Treasury was more concerned about averting financial meltdown than negotiating a good deal for the taxpayer. Yet now, after averting the banks from bankruptcy, the banks seem to be in a state of ’employee capture.’ Bank employees are grabbing capital provided by their shareholders to enrich themselves rather than using it to recapitalize their banks. That’s not supposed to be how capitalism works.

And that’s because capitalism in the banking sector has been distorted by moral hazard — the concept that bankers will continue to take excessive risks with other people’s money as long as they know that the government will be there to bail them out.

The concept of moral hazard is against the instinct of all free market economists. In capitalism, if you take big risks and fail, you go bankrupt. That’s the end of it. In the banking sector however, several banks took large risks, secure in the knowledge that they were too big to fail.

Now I’m not going to argue why we need to save big banks — that’s obvious — the economy would collapse if the banking system collapsed.

What I want to focus on is why have banks taken on such big risks. And that leads me to the conflicts of interest that continue to plague the banking sector.

Conflicts of interest
Now there are many types of conflicts of interest within a large investment bank. My book, City of Thieves, for example, covers one type of conflict – the conflicts an analyst faces every day. He’s under pressure to change a rating because somebody somewhere in the bank stands to make a lot of money by manipulating stock ratings. That type of conflict is well documented. It was headline news in 2002, when Eliot Spitzer, the New York attorney general humiliated the top 10 U.S. investment banks by pointing out that analysts like Merrill Lynch’s Henry Blodget were telling clients to buy internet stocks whilst internally saying they were crap.

Spitzer fined the banks $1.4 billion for allowing these conflicts to go unchecked. A year later he was very publicly discredited when he found himself embroiled in a prostitution racket. That was pretty convenient for the banks. Since then very few regulators have had the guts to take on the banks with quite the same vigor and success as Spitzer. So the banks just returned to business as usual. Back to precisely the same bad old tricks, for which they had been fined $1.4 billion back in 2003 by Wall Street’s highest ranking law enforcement officer.

As a result of the conflicts exposed by Spitzer, pension funds and other big investors still — to this day — do not trust the stock research flowing out from the big banks. There’s always an angle, always a hidden agenda behind it. An analyst at a big bank is supposed to provide independent analysis. But he has a lot of big hitters to please back at head office — the commercial lending guys, the M&A guys, the equity capital markets team, the derivatives team and the fixed income guys. And it shows in their research.

Going one step higher than conflicts faced by stock analysts, the mother of all conflicts of interest is how banks handle your money. Remember bank’s sell trust. You give them you’re money and trust you can get it back any time. You might even pay them a fee to hold it. You expect them to take care of it, to put it in safe investments. But of course safe investments don’t generate big returns. Risky investments generate big returns… and big bonuses.

So the biggest conflict of all in a bank is that bankers are tempted to put money — your money — that should be destined for safe investments into risky investments, without telling you about it.
It’s a major conflict because it goes to the very heart of what banks are — custodians of our money.

Conclusion
All throughout my career I saw the good guys in the city fall like flies. Those who refused to follow questionable practices were laughed at and thrown out onto the street. They weren’t part of the club. They were the losers. Greed was good. Well, nobody’s laughing at the good guys now. There aren’t enough of them.

As a society, our livelihoods and even our happiness are to a large extent determined by the morals and values that we are taught to hold dear. They are ingrained in us from an early age and they form the fiber of our being. We never really think about them until they are undermined.

Until the culture within the banking sector is systematically overhauled by regulators whose policies reflect the moral code of our society as a whole, we will never put our banking sector in order.